Income Report / Income Report; Rio Tinto (RIO) Buy Back – A sign of what’s to come! (RIO, TRS, AWC, NBI)

By Market Matters 26 September 18

Income Report; Rio Tinto (RIO) Buy Back – A sign of what’s to come! (RIO, TRS, AWC, NBI)

Market Matters Income Report 26th September 2018

The market is trading higher this morning thanks largely to more buying amongst the resource stocks – Rio Tinto (RIO) trading up another ~1.5% through $80 while CBA is down another ~0.50% testing the $70 region. Banks remain on the nose in Australia ahead of draft findings from the Royal Commission due out on Friday while resources have regained their mojo.

In terms of the MM Income Portfolio for the week, it fell by -0.24% while the market was up 0.40%. Fortescue (FMG) had a good week and has punched up through the $4 handle this morning.  The portfolio is now up 1.66% this financial year, and +7.76% from inception vs the benchmark which is tracking at 1.30% & 6.74% respectively. The expected yield on the portfolio is ~6.90% inclusive of franking, which is slightly lower on the week given the removal of the BENPG and the addition of NBI which starts trading today at 11am.

Rio Tinto (RIO) Buy Back – A sign of what’s to come!

Its seems there could be a perfect storm for the release of franking credits from company balance sheets with a combination of asset sales (mainly the miners) and the potential change in Government which in simple terms would make franking credits less valuable. That could mean that Aussie corporates are incentivised to announce special dividends or undertake off market buy backs. Last week, RIO was the first cab off the rank announcing a range of capital management initiatives that revolved around buying back stock - in the UK the company will buy back stock on market while in Australia this will be an off market deal, and the structure will be attractive for those shareholders that pay no tax, or enjoy a low tax rate – something south of ~20%.

Here’s why. The deal is structured as a small capital amount and a large fully franked dividend. The franking benefit for those in a zero or low tax environment creates the opportunity. While the pricing of the deal will play out during October, based on the current prices the offer will make sense for some holders.  

In short, RIO has made an offer to buy back stock at a discount to the market price – somewhere between an 8% and 14% discount. Given recent history the 14% discount will likely play out. So, for explanation sake, based on yesterdays close of $79.11 RIO will offer to buy back shares at $68.03 – a poor deal on face value. However, the deal is structured with a small capital component ($9.44) and the balance being a fully franked dividend.

Subtracting the capital component of $9.44 from the assumed offer price of $68.03 ($79.11 minus 14%), we get a dividend amount of $58.50 fully franked. The gross value (after franking) of that dividend is therefore $83.57 ($58.59/0.7)  plus the $9.44 capital component giving a total value of $93.15 after tax for those currently enjoying a zero tax environment.

Breakdown up of RIO’s off market buy back.

For those in a super fund paying 15% tax there is still a benefit of around 9% based on the assumed prices. The cut off seems to be around the 27% mark in terms of tax rate.

Clearly this is a good deal for some. Because of that, the discount will probably be 14% and the deal will likely be substantially oversubscribed – or at least that’s been our experience with these sort of things in the past where we tender shares, take market risk on our stock only to see the allocations be so low that we simply lose 10-20% of the shares tendered and keep the rest.  

Also worth noting that BHP will likely roll out a similar approach but on a larger scale. They’ve sold $10.8b of shale assets and the proceeds will come back to shareholders in two tranches, the first at the end of Oct / early Nov probably via a combination of on-market and off market buy backs.  

Rio Tinto (RIO) Chart

Companies with BIG franking credit balances

Macquarie Research do a good franking report with the last one (that we can see) out in June 18. The below chart highlights the large franking balances as a percentage of the company’s market capitalisation. Surely these companies will look to address this before the next election?? BHP is the next cab off the rank however there are many potential candidates. Harvey Norman (HVN) made an interesting move raising capital for ‘international expansion’ when they reported results last month but they also paid a big dividend. If you recall back in 2014, HVN raised $120.7m in new equity simply to pay a special dividend of 14cps fully franked. That was an innovative move at the time to get franking credits off balance sheet, however the ATO took a dim view of it. This time Gerry wrapped it in different paper, however he clearly likes to push the envelope -  understandable given  he owns 344m shares in HVN or ~30% of the company.

The below are companies worth monitoring for income opportunities before the potential change in franking credit legislation.

One concern for these companies could be a lack of cash preventing them from launching a buyback or paying special dividends to reduce their franking balance. While buy-backs require a large cash component to distribute franking, a dividend reinvestment plan (DRP) on a special dividend can counteract this problem where the franking is paid away by giving new shares to shareholders instead of cash while the company underwrites the DRP to eliminate the risk of a shortfall.

The Reject Shop (TRS) $4.94 – is there value in franking?

The Reject Shop (TRS) clearly stands out here with franking credits equalling around 30% of their market capitalisation – which is huge, however buying a stock for income / franking credits or any other singular reason can often end in tears. While TRS is dirt cheap (8.6x expected FY19 earnings) and is expected to yield 7.6% fully franked on a 60% payout ratio, it does have its challenges. TRS is positioned as a discount retailer in a period when Aldi, Lidl and AMZN are all scaling in the Australian market. Life for like sales have been declining with a cost out program yet to offset the earnings deterioration. While they’re doing some positive things to improve the business particularly around the supply chain, it all seems a bit of a challenge for TRS at the moment, and the technical picture on the charts is a messy one.

Still, TRS is a stock worth keeping on the radar as an income opportunity.

The Reject Shop (TRS)  Chart

Alumina (AWC)  $2.76 – skewing more towards inflation

Alumina (AWC) has been in the MM Income portfolio in the past – we bought at $1.96 and sold at $2.17 plus we picked up an 8cps dividend along the way. The stock is clearly trading above that level now however markets are fluid and we’re again looking at AWC from an income perspective.  AWC is one of only a handful of mining sector names that have stock specific tailwinds offsetting to a large extent the sector headwinds of tariff’s and USD strength.

The stock is expected to yield 6.3% fully franked in FY19, trading on an estimated P/E of 14x.

·         MM are bullish AWC targeting ~$3.20

Alumina (AWC) Chart

NB Global Corporate Income Trust – Lists today at 11am under code ASX code NBI

The income trust raised a tad over $413m showing some decent demand across the market for this diversified sort of bond offering. That was at the upper end of the target raising of $150-500m. We added it to the MM Income Portfolio with a 5% weighting, reducing our exposure to bank hybrids overall. The NBI aims to pay monthly income at rate of 5.25% p.a.. They invest in senior fixed rate hedged USD corporate bonds of large, liquid companies globally.

Conclusion (s)

-          Rio’s off market buy back makes sense depending on an individual’s tax situation, however expect significant scale back

-          The Reject Shop (TRS) looks cheap, and the company has a huge franking balance

-          We are bullish Alumina (AWC)

Have a great day!

James, Harry & the Market Matters Team


Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.


All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 26/09/2018

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